OTC Derivatives Reform: Estimating Collateral Demand and Regulatory Impacts on the Market

2. OTC derivatives reform and estimating collateral demand ‘I think there is a world market for maybe five computers’ - Thomas Watson (1943), Chairman of IBM Che Sidanius Advisor Financial Stability

3. Agenda

5. Regulatory reforms • G20 commitments • Increased regulation & supervision of derivatives market participants, including pension funds and insurance firms; • Greater standardisation of derivatives contracts; • Mandatory clearing through central counterparties (CCPs) • Margin requirements for bilateral contracts • Increased transparency (pre- and post-trade) and trade reporting • However, together with other regulatory reform... • Liquidity coverage ratio – promotes short-term funding • CCP default fund contributions (PFMI) • Basel III & Solvency II – increases need for high quality assets

6. OTC reforms: Demand vs supply impact • Direct impact channel: increased demand for high-quality, liquid assets • As collateral for OTCD transactions (cleared and non-cleared) • As liquid asset buffers (Basel III liquidity regulation) • As collateral in securities and repo lending (shadow banking) • Indirect impact channels: limitations on collateral velocity • Restrictions on collateral re-use/re-hypothecation (OTCD; shadow banking) • Greater use of account segregation (encouraged by regulation)

7. OTC reforms: Demand vs supply impact cont. Outstanding amounts of potentially safe assets (US$ trillions and percent in total) • Direct impact channel: supply of high-quality, liquid assets • AAA/AA government-securities outstanding: US$33 trillion (IMF) • However, significant amount held by CBs, long-term investors, or repo markets • Sovereign debt considered safe could fall by US$9 trillion by 2016 Source: IMF (2012)

9. OTC derivatives market – overview OTCD notional outstanding and world GDP ratio • $650 trillion in notional amount outstanding (BIS) • More than 10x world GDP • IRS – around 78% of OTCD market • Highly standardised • USD, EUR, Yen, GBP: 83% of notional value (FRBNY) • Mostly short-term tenor (<1 yr) • CDS – around 4% of OTCD market • USD, EUR: 98% of notional value (FRBNY) • Significant activity in 5 yr maturities Source: BIS, IMF and Bank calculations (2012)

10. OTC derivatives reforms: Estimating initial margin • Several studies; however, different scope, assumptions and methodologies

11. OTC derivatives: market opaque

12. OTC derivatives reform – intended to shed light, not heat

13. BoE quantitative approach • Objective: Consider methodology carefully when estimating collateral demand? • Netting • Rehypothecation • Market conditions • Our data sources: trade repositories & CCPs • Volume/value • Type of market participants • Margin models • Benefit: transparency, modifiable, replicable & provides a range

14. Quantitative estimates: our methodology Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional

15. Quantitative estimates cont: our methodology Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional 2. Netting ratio/proportion cleared

16. Quantitative estimates cont: our methodology Product scope: IRS & CDS (80% of total OTCD market) 1. Gross notional2. Netting ratio/proportion cleared 3. Apply VaR to estimate IM Ten-day VaR

17. Quantitative estimates cont: our methodology Gross notional in IRS TR data breakdown: • TriOptima for IRS: ~ 50% centrally cleared

18. Quantitative estimates cont: our methodology Gross notional in CDS Gross notional in IRS TR data breakdown: • TriOptima for IRS: ~ 56% centrally cleared • DTCC for CDS: ~ 10% centrally cleared

19. Quantitative estimates cont: our results for IRS & CDS Total IM : US$200-800 billion • 80% centrally cleared • Netting assumptions • Bilateral: no rehypothecation & 10-day VaR; Cleared: no rehypothecation & 5-day VaR

20. Quantitative estimates cont: results for IRS Total IM demand (US$ billions, ‘normal’ market conditions): netting matters

21. Quantitative estimates cont: results for CDS Total IM demand (US$ billions, ‘normal’ market conditions): Regulatory impact netting range

22. Effect of rehypothecation – IRS & CDS • Proposed rule would limit rehypothecation (IOSCO) CDS market IRS market

23. Effect of market conditions - methodology • Margin rates vary with market conditions • ‘Normal’ market conditions – avg. volatility during 2006 -2011 • ‘Tranquil’ market conditions – 2/3 of average volatility (e.g. January 2006) • ‘Stressed’ market conditions – 2x average volatility (e.g. October 2008)

24. Effect of market conditions: results for IRS & CDS • Under ‘stressed’ conditions - total IM for cleared and non-cleared may reach up to US$ 1.7 trillion • Haircuts applied to non-cash collateral CDS market IRS market

25. Pace of transition • Clearing obligation & margin rules for non-cleared contracts expected to affect new contracts • Pace of transition depends on maturity profile*

27. Final thoughts • Financial stability issues • OTCD reform benefits: • Counterparty credit risk • Transparency • Collateral demand vs supply; asset encumberance • Fragmentation of clearing, reduction of netting • Pro-cyclicality issues • Market response on-going • Compression, netting efficiencies, collateral transformation, cross-margining

28. Market response cont.

29. Market response cont.

30. References • OTCD reform and collateral demand impact (BOE): http://www.bankofengland.co.uk/publications/Pages/fsr/papers.aspx • Safe assets: financial system cornerstone (IMF): http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/c3.pdf • An analysis of CDS transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr517.html • An analysis of OTC IRS derivatives transactions (FRBNY): http://www.newyorkfed.org/research/staff_reports/sr557.html